The same type of sub-prime mortgage lending crisis that rocked the world in 2008 could be set for a repeat in Australia, as many of the 1.5 million households with interest-only loans are expected to struggle with repayments.
Increased interest rates could deepen this issue, with even higher repayments predicted to be out of the question for many households.
Digital Finance Analytics Principal Martin North confirmed that $700bn of the $1.7tn value of Australian mortgages comes from interest-only loans. He added that this issue is as serious as the tipping point that led to the Global Financial Crisis (GFC) ten years ago.
North stressed that Australia is in a similar position to the US in 2006 before the GFC took hold around the world and that several precursor signs are on show.
This has led to a knock-on effect in the banks’ ability to offer mortgages to consumers, with an estimated one in five no longer expected to receive the same mortgage that they would have been approved for just two or three years ago.
In part, this is because the regulator and the Royal Commission have been looking harder at what deals are on offer and are cracking down on irresponsible lending to try and ward off any imminent sub-prime mortgage crisis.
One of the leading contributors to the prior crisis was the number of over-leveraged households that were suddenly defaulting at once, especially when the rates changed and the so-called “honeymoon” period ended. However, it is worth noting that in the US at the time, vastly disproportionate mortgages were handed out even to those on minimum wage or with no income.
North was clear to point out that Australian banks have not been guilty of such a practice at this stage. However, there is clear evidence of big loans being offered to consumers who could at best only look to service the interest on the debt.
UBS Evidence Lab carried out research suggesting that in the event of an inability to service current interest-only loans, most households would initially look to reduce outgoings and consumption where possible to try and match the shortfall. Others would just sell their properties.
The ability for banks to reset the interest levels being passed on through these mortgages is technically possible, though difficult. In accounting terms, there is uncertainty regarding how much is absorbable at any one time, with cash flow problems being a potential short-term issue for smaller banks that opt for this.
Households choosing to refinance their mortgages would pose an immediate issue to banks, as they would have to restructure their interest-only loans dealt to consumers, which currently cap at 30% and come in at around $40bn every quarter.
Changing what banks can put onto their back books (what they lent out in the past) could become a more viable option. Banks could allocate up to $25bn per quarter as they seek to use front and back book accounting to maximize their ability to reset some interest rates and avoid all permutations of a sub-prime crisis.
Post-2008, the US struggled for four years until it was able to carry out some sort of reset. House prices finally rose, and the US economy is slowing finding its feet again.